There is no guarantee of success in the stock market, but smart investors are always trying to improve their chances. The father of value investing, Benjamin Graham, laid out 10 timeless criteria that, if met by a company, get you as close to that elusive guarantee as possible.
One of these rules is to pay no more than two-thirds of the net current asset value (NCAV) for a company. Net current asset value is the difference between current assets and total liabilities, effectively measuring the amount of liquid assets a shareholder can lay claim to. It's a powerful tool for estimating the margin of safety, and we all know how important that is.
The logic behind Graham's rule is twofold, involving safety and value. In the event of bankruptcy, current assets will be converted to cash at close to their carrying value, so by paying less than two-thirds of net current asset value, you're likely to get most of your initial investment back after paying off all the liabilities. (This logic applies only if you actually buy a company, not its stock; stockholders rarely recover anything in the event of bankruptcy.)
Theoretically, you break even before you sell the long-term assets, which may not fetch anywhere near the carrying value on the balance sheet. Plus, from a value perspective, paying less than NCAV is like buying only the liquid assets in the company, while getting the fixed ones for free.
Of course, we're talking about ideal situations here, and in today's overvalued (in my opinion) stock market, it's nearly impossible to find a company trading at a discount to its net current asset value. You can, however, find companies with at least positive NCAV, including some big names like Microsoft
Graham's NCAV rule represents the essence of conservative value investing. It guarantees nothing, but it does put the odds of success in your favor. And when you're dealing with a creature as fickle as Mr. Market, that's about the best you can expect.
Chris Mallon does not own any of the companies in this article, but he is hiding under the desk waiting for your emails .
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